China is up 2 million barrels a day but oil is not going anywhere. It appears there is “ample supply in the market for us to not have a big impact from China coming back.”
Margin debt has fallen more than 30% from its October ’21 peak. That is a similar range to the 2020 contraction, during the pandemic, but far behind the +50% contractions seen during the Dotcom crash (2000-2002) and the global financial crisis (2007-2009).
The S&P fell 49% during the Dotcom crash and 57% during the GFC. The low point in June showed a 24% fall, from the January peak, followed by a 7.5% rally.
Plunging margin debt confirms a bear market, in line with the Fed’s plan to force deleveraging in order to shrink aggregate demand and curb inflation.
The current rally on the S&P 500 is typical of a reflexive rally in the middle of a bear market. We expect further contraction in margin debt as interest rates rise and liquidity tightens. Our target is a 50% contraction in margin debt, with a similar fall in the S&P 500, to 2400.
- Hat tip to Advisor Perspectives for the margin debt chart
- FINRA for the margin debt data
Stanley Druckenmiller, former partner of George Soros, runs his own family office at Duquesne Capital. His record of compounding assets at 30%+ per year for 30 straight years is unmatched.
Interesting audio interview with Stephen Kotkin in Foreign Affairs.
“We tend to exaggerate the influence that our policies have in Russian behavior, Iranian behavior, Chinese behavior….They’re ancient civilizations that preexist the United States by many, many centuries. And there are internal dynamics there that are deep, profound…. It’s not to say that there weren’t major policy mistakes. Of course there were policy mistakes. In retrospect one can criticize many things that the West did. You just can’t get that to be the prime driver or explanation for where we are with Russia today…”
“In many ways, systems select for leaders. You can get into power randomly through some accident, if you’re appointed, or there’s a death—you name the cases where there’s an accidental rise to power of a figure. But you can’t stay in power for 20 plus years accidentally. You actually have to sustain yourself in power, and that’s much harder, more complex. And so the random characters who might get in are not there 20 years later. But then they’re transformed by being in that position.
The argument of Stalin….. is that he wasn’t a fully formed personality before he got to the position of being the despot of the Kremlin. It was being in that position that made him the figure that we know. Something happened to Putin as well…..”
Michael Every from Rabobank is bearish on Gold in his recent video:
“I can’t see the case for Gold while the Fed is hiking — you don’t get a correlation with the Fed hiking aggressively and Gold going up…..If you want to buy into the Gold argument you are buying into the end of the US system. You are implicitly backing a New World Order and Commodity-backed currencies.”
Several readers have written, asking if this changes our view on Gold.
The short answer is NO, for three reasons:
1. The Fed can only hike rates until something breaks
Michael qualifies his view: he is bearish on Gold while the Fed hikes interest rates.
The Fed is expected to tighten — but only until something breaks. Not stocks, which they are unlikely to support, but the bond market. Credit is the lifeblood of the economy. When it stops flowing, the Fed is forced to inject liquidity into financial markets to maintain the flow.
Bank credit still grows at a healthy rate.
The ratio of Copper/Gold (orange below), however, is a good indication of the economic cycle. When the economy is growing — and long-term interest rates (blue) are increasing — industrial metals, like Copper, rise faster than Gold and the ratio rises. When the economy contracts, the ratio falls.
Copper/Gold going sideways at present warns that the global economy is stalling. It is highly unlikely that the Fed would continue to tighten if the economy starts to contract — which would be signaled by a falling Copper/Gold ratio.
Consumer sentiment (blue, inverted scale below) also gives a recession warning, at levels normally associated with high unemployment (red).
Investment grade corporate bond issuance (green below) is still within its normal range, albeit on the low side, but high yield (light blue) has slowed to near its March 2020 low, warning that we are close to an economic contraction.
A fall of investment grade issuance below $50 billion (the Dec 2020 low) would be cause for concern.
2. A strong Dollar is destroying US industry
The US has been running twin deficits for several decades, supporting the US Dollar as global reserve currency and offering US Treasuries as the global reserve asset.
This has allowed the Financial sector to grow to a point where it dominates the US economy.
Wall Street may be reluctant to relinquish their “exorbitant privilege” of cheap debt but it has come at a huge cost to the US economy.
In order to supply international financial markets with sufficient Dollars, the US has to run large trade deficits. But every foreign exchange transaction has to have a buyer and a seller, so the large outflow of Dollars on current account is balanced by an equal and opposite inflow on the capital account.
The resulting trade imbalance boosts the Dollar exchange rate to the point that US manufacturers find it difficult to compete against foreign manufacturers in export markets and against foreign imports in domestic markets.
The strong Dollar decimated the manufacturing sector which has shed almost 7 million jobs over the past four decades.
The inflow of surplus capital also encourages malinvestment in nonproductive areas — dressed up to look attractive through leverage and artificially low interest rates — as in the sub-prime crisis. The ratio of GDP (output) to private non-financial debt has declined by more than 50% since the 1960s.
Cheap debt also enabled the federal government to run large deficits at low cost, spending more than they raised in taxes and softening the impact of the growing trade imbalance.
The largest portion of capital inflows was invested in Treasuries. As the Current account balance plunged, federal debt held by foreign investors ballooned to almost $8 trillion.
3. US debt above 120% of GDP would destroy the bond market
Overall federal debt climbed to more than 120% of GDP, well above the sustainable level of 70% to 80% of GDP posited by Dr Cristina Checherita and Dr Philip Rother in their ECB study of highly indebted economies.
Earlier research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggested that states where sovereign debt exceeds 100% of GDP almost inevitably default.
That doesn’t mean that the US is about to default but it does mean that the federal government is precariously close to the point of no return, where it can no longer service the interest on its debt and is forced to capitalize it, compounding the problem.
The only viable alternative is inflation. If the borrower suppresses interest rates below the rate of inflation, then GDP is likely to grow faster than the debt. This is already evident on the chart above, where US debt-to-GDP fell in the past 12 months. Federal debt (yellow) increased, but nominal GDP (blue) grew faster because of inflation.
The global financial system — with a US Dollar reserve currency and US Treasuries as the global reserve asset –appears increasingly fragile as global geopolitical conflict escalates.
China & the Dollar
After China’s admission to the World Trade Organization (WTO), it rapidly accumulated foreign reserves — mostly US Dollars — as it built up its industrial base, reaching $4 trillion by 2014.
China maintained a strict peg against the Dollar until 2014, only allowing it to gradually rise in response to US pressure. But in 2014, a surging Dollar — in response to falling CPI and a shrinking deficit — started to cause problems.
The peg to a strong Dollar started to hurt Chinese exports; so in 2014 the authorities allowed the yuan to weaken, easing capital controls. Capital outflows and a falling Yuan attracted speculators like Hayman Capital who shorted the currency, forcing the PBOC to step in to support the currency in 2017.
In 2018, the Yuan again fell when Donald Trump imposed tariffs on China’s exports to the United States, setting off a trade war.
The third major fall, in 2022, is the result of China’s debt crisis. An over-leveraged economy threatens to contract — triggered by rising US interest rates, a strong Dollar, rising energy prices, and an ongoing pandemic — while regulators attempt to shore up the financial system.
The Belt-and-Road initiative
In 2013 the PBOC were unhappy with the Fed’s program of quantitative easing (QE) which could be seen as currency debasement at the expense of foreign creditors (China).
China’s response was the Belt-and-Road initiative (BRI). This loaned US Dollars to emerging market governments in exchange for lucrative construction contracts, secured against the underlying infrastructure assets. Africa was a prime target.
The capital inflow was diverted from US Treasuries — funding the federal deficit — and into the BRI. By 2022, BRI loans — denominated in Dollars to maintain the Yuan’s trade advantage over the Dollar — amounted to close to $5 trillion.
Funding the federal deficit
China’s BRI left Treasury with a problem with funding the US deficit, So far, the gap has been filled by Fed QE and, to a lesser extent, commercial banks.
But QE is not a long-term solution. The twin deficits supporting the US Dollar status as global reserve currency are now broken. And US Treasuries are no longer attractive to foreign investors as the global reserve asset.
The US is faced with a difficult choice:
- Allow the Fed to continue its easy monetary policy in the hope that inflation will bail Treasury of its serious debt problem, lowering federal debt to between 70% and 80% of GDP. The risk is that foreign investors will increasingly shun Treasuries, threatening its status as the global reserve asset and driving up long-term interest rates in the USA.
- Encourage the Fed to adopt a hawkish stance, shrinking its balance sheet (QT) and raising interest rates. Lower inflation and a stronger Dollar would restore investor confidence in Treasuries. But the risk is that the US plunges into recession which would make the debt problem even worse. Tax revenues would fall during a recession, increasing the fiscal deficit.
It appears that the Fed are attempting to walk a fine line between the two options at present, talking tough but delaying action for as long as possible, but later this year, they will be forced to show their hand.
Rising US interest rates and the strong Dollar are a major problem for China. Not only is the strong Dollar undermining Chinese businesses who borrowed in USD at cheap rates, but the strong Dollar also threatens to collapse China’s $5 trillion Belt-and-Road initiative which is funded by USD-denominated loans. Despite official statistics, the country is in a heap of pain. The private sector has never fully-recovered from the initial COVID-19 pandemic and is now being dragged down by Xi Jinping’s zero-Covid policy lockdowns. Ports are in gridlock.
Falling natural gas consumption warns of an economic contraction, promising further disruption to commodity producers and supply chains around the world.
This may be an over-simplification but “team USA” — to use Michael Every’s expression — is primarily split into two camps:
- Wall Street and the Federal Reserve, who want to maintain the US Dollar position as the global reserve currency; and
- The Department of Defense (DOD) and the manufacturing sector, who recognize the damage done by the Dollar reserve currency, with erosion of the US industrial base and offshoring of critical supply chains.
Weaponizing the Dollar against Russia, by seizing their foreign reserves, was apparently a DOD initiative, with the Fed not even consulted. The outcome is likely to be long-term damage to the Dollar’s reserve currency status, with non-aligned states — including China and India — increasingly reluctant to hold reserve assets in Dollars.
There are no ready alternatives to the Dollar — as Michael Every points out — but other asset classes, including Gold and Commodities, are likely to play an increasingly larger role.
Credit markets are tightening and warn of a recession. The Fed is unlikely to continue its hawkish stance if credit markets dry up or employment falls.
It is not in the US interest to continue running large current account deficits to support the Dollar’s reserve status. The economy has suffered long-term damage from its “exorbitant privilege” with the US Dollar as reserve currency. Support for the Dollar’s reserve status, from Wall Street, faces growing opposition from the DOD and manufacturing sector.
The US faces a tough choice between debt and inflation. A hawkish Fed may lower inflation but is likely to cause a recession, making the debt situation even worse. A dovish Fed, on the other hand, with higher inflation, may alleviate the debt problem but is likely to undermine foreign investor confidence in the Dollar and Treasuries.
The situation is further exacerbated by current market turmoil. The strong Dollar threatens to damage China’s economy and its Belt-and-Road initiative, raising tensions with the US. Weaponization of the Dollar in sanctions against Russia also threatens to undermine the Dollar’s reserve currency status.
Rising interest rates and a strong Dollar are bearish for Gold, but there are a number of developments that suggest the opposite. We remain overweight on Gold.
Bill Dudley, former FRBNY Pres and Goldman Sachs Chief US Economist says the Fed will have to drive up unemployment to keep inflation in check. When the Fed has done that in the past it has always resulted in a recession. Bond yields will have to rise and stocks will have to fall in order for the Fed to succeed in taming inflation.
Hat tip to Joseph Wang.
“A lot of Russians want what Ukrainians have” — makes it clear why Vladimir Putin views Ukraine as a threat.
Independent channel TV Rain enjoyed dramatic increases in Russian viewership (+/- 25 million viewers) during the latest Ukraine invasion — illustrating Russians’ need for independent and objective news. But it was shut down by the latest security legislation.
Preliminary Q1 results from S&P Dow Jones Indices show S&P 500 dividends and buybacks continue to exceed reported earnings in the first quarter of the current year.
While this could be a spill-over of offshore funds repatriated as a result of the 2017 Tax Cuts and Jobs Act, companies have distributed more than they earned since 2014 (Q4). That leaves nothing in reserve for new investment or increases in working capital, both of which are necessary to support growth.
In my last post I highlighted that before-tax corporate profits, adjusted for inflation, are below 2006 levels and declining. Reported earnings for Q1 2019 on the above chart (preliminary results) are only 3.5% higher than the same quarter in 2018. If we strip out inflation, estimated at 2.0%, that leaves only 1.5% real growth.
S&P 500 earnings per share growth for Q1 2019 is marginally better, at 6.1%, because of stock buybacks.
But the S&P 500 buyback yield is 3.49% (Source: S&P Dow Jones Indices). On its own, that should boost eps growth by 3.6% (1/[1 – 0.0349] – 1 for the quants). There seems to be 1.0% missing.
Warren Buffett has pointed this issue out repeatedly for the past 20 years:
“…We will repurchase stock when it falls below a conservative estimate of its intrinsic value. We want to be sure that when we repurchase shares that the remaining shareholders are worth more the moment after we repurchased the shares than they were before.”
If stock is repurchased at above intrinsic value then shareholders will be worse-off. The company receives a poor return on its investment in much the same way as if it had over-paid for an acquisition.
Here is a simple example:
If a company is trading at 100 times earnings and achieving 20% organic earnings growth per year, it is most likely over-priced. Now that company buys back 10% of its own stock (numbers are exaggerated for illustration purposes). Earnings will stay the same but earnings per share (eps) increases by 11.1% (the inverse of 90%).
If the same funds used for the buyback had been invested in a new project with a modest 5% initial return on investment, earnings would have increased 50% (and eps likewise).
The larger the buyback yield, the more that growth is likely to deteriorate — especially when earnings multiples are dangerously high.
There has been talk in recent months about the narrowing yield curve and how this warns of a coming recession, normally accompanied by a graph of the 10-year/2-year Treasury spread which fell to 0.22% at the end of August 2018.
I have always used the 10-year minus the 3-month Treasury spread to indicate the slope of the yield curve but, although this shows a higher spread of 0.71%, both warn that the yield curve is flattening.
Is this cause for alarm?
First of all, what is the yield curve? It is the plot of yields on Treasuries against their maturities. Long maturity bonds normally have higher yields than short-term bills, to compensate for the increased risk (primarily of interest rate changes). If you tie your money up for longer, you expect a higher return. That is a rising yield curve.
A steep yield curve is a major source of profit to banks as their funding is mostly short-term while they charge long-term rates to borrowers, pocketing the interest spread.
The Fed sometimes intervenes in the market, however, restricting the flow of money to the economy, to curb inflation. Short-term rates then rise faster than long-term rates and the yield curve may invert — referred to as a negative yield curve.
At present we are witnessing a flattening yield curve, as short-term rates rise close to long-term rates.
A recent paper from Michael D. Bauer and Thomas M. Mertens at the San Francisco Fed concludes that a narrow yield differential has zero predictive ability of future recessions:
In light of the evidence on its predictive power for recessions, the recent evolution of the yield curve suggests that recession risk might be rising. Still, the flattening yield curve provides no sign of an impending recession. First, the evidence suggests that recession predictions based on the yield curve require an inversion (Bauer and Mertens 2018); no matter which term spread is used to measure its shape, the yield curve is not yet inverted. Second, the most reliable summary measure of the shape of the yield curve, the ten-year–three-month spread, is nearly 1 percentage point away from an inversion.
I was pleased to see that Bauer and Mehrtens find the 10-year/3-month Treasury spread more reliable than other spreads in predicting a recession within 12 months, with 89% predictive accuracy. They also refer to another study that came to a similar conclusion:
Engstrom and Sharpe found that their short-term spread statistically dominated the 10y–2y spread, and our findings are consistent with this result.
But both studies conclude that a negative yield curve (when the yield differential is below zero) is a reliable predictor of recessions. And Bauer and Mehrtens observe that, while the 10 year/2 year spread is less accurate, it is still a reliable predictor.
Are we just 22 basis points away from a recession warning? Let’s weigh up the evidence.
First, a negative yield curve is a reliable predictor of recessions. In the last 60 years, every time the 10-year/3-month spread has crossed below zero, a recession has followed within 12 months. There is one arguable exception. In 1966 the yield differential crossed below zero, the S&P 500 fell 22% and the NBER declared a recession, but they (the NBER) later changed their mind and airbrushed it out of history.
Second, while there is strong correlation between the yield curve and recessions, the exact relationship is unclear.
The most convincing explanation is that bank interest margins are squeezed when the yield curve inverts. When it is no longer profitable for banks to borrow short and lend long, they restrict the flow of new credit. Credit is the lifeblood of the economy and activity slows.
That was clearly the case in the lead up to the 2008 crash, but why are net interest margins of major US banks now widening?
The flow of credit also slowed markedly before the 1990/1991 recession but did not ahead of the last two recessions.
And growth in the broad money supply — zero maturity money (MZM) plus time deposits — accelerated ahead of the Dotcom crash and 2008 banking crisis.
Third, consider the Wicksell spread. Swedish economist Knut Wicksell argued in his 1898 work Interest and Prices that the economy expands when return on capital is higher than the cost of capital, with new investment funded by credit, and it contracts when the expected return on capital is below the cost of capital.
I was first introduced to Wicksell by Neils Jensen, who uses the Baa corporate bond yield as a proxy for the cost of capital and nominal GDP growth for the return on capital. Neils argues that the economy is near equilibrium when the Wicksell spread is about 2.0% — when return on capital is 2.0% higher than the cost of capital.
The above graph shows that 1960 to 1980 was clearly expansionary, with nominal GDP growth exceeding the cost of capital (Baa corporate bond yield). But the last almost four decades were the opposite, with the cost of capital mostly higher than the return on capital. Only recently has this reversed, suggesting a new expansionary phase.
One could argue that low-grade investment bond yields are a poor proxy for the cost of capital, with rising access to equity markets in recent decades. Also that nominal GDP growth rate is a poor proxy for return on capital. If we take the S&P 500, the traditional method of calculating cost of equity is the current dividend yield (1.8%) plus the dividend growth rate (8.0%), giving a 9.8% cost of capital. If we take the current S&P 500 earnings yield of 4.0% (the inverse of the P/E ratio) plus the earnings growth rate of 15.1% as the return on capital (19.1%), it far exceeds the cost of capital. You can understand why growth is soaring.
New capital formation is starting to recover.
Fourth, Fed actions over the last decade have distorted the yield curve. More than $3.5 trillion of Treasuries and mortgage-backed securities (MBS) were purchased as part of the Fed’s quantitative easing (QE) strategy, to drive down long-term interest rates. In 2011 to 2012, the Fed also implemented Operation Twist — buying longer-term Treasuries while simultaneously selling shorter-dated issues it already held — to further bring down long-term interest rates. Long-term rates are still affected by this.
In addition, Fed efforts to shrink their balance sheet may further distort the yield curve. The Fed has indicated that it will not sell Treasuries that it holds but will not reinvest the full amount received from investments that mature. If we consider that short-term Treasuries are far more likely to mature, the result could be that the maturity profile of the Fed’s Treasury portfolio is getting longer — a further extension of Operation Twist by stealth.
A flat yield curve does not warn of a coming recession. A negative yield curve does. Both the 10-year/2-year and 10-year/3-month Treasury spreads are reliable predictors of a recession within 12 months, but the 10-year/3-month spread is more accurate.
The correlation between the yield curve and recessions is strong but the actual relationship between the two is more obscure. Links between the yield curve, bank net interest margins, bank credit growth and broad money supply growth are more tenuous, with lower correlation.
Also, return on capital is rising while cost of capital remains low, fueling strong capital formation. The economy is starting to grow.
Fed actions, through QE, Operation Twist, and even possibly steps to unwind its balance sheet, have suppressed long-term interest rates and distorted the yield curve. While the yield curve is still an important indicator, we should be careful of taking its signals at face value without corroborating evidence.
Lastly, we also need to consider the psychological impact. If the market believes that a negative yield curve is followed by a recession, it most likely will be. Beliefs lead to actions, and actions influence outcomes.
Treat yield curve signals with a great deal of respect, and be very wary of how the market reacts, but don’t mindlessly follow its signals without corroboration. The economy may well be entering a new growth spurt, with all its inherent dangers — and rewards.
I contend that financial markets never reflect the underlying reality accurately; they always distort it in some way or another and the distortions find expression in market prices. Those distortions can, occasionally, find ways to affect the fundamentals that market prices are supposed to reflect.
~ George Soros
First, the good news from the RBA chart pack.
Exports continue to climb, especially in the Resources sector. Manufacturing is the only flat spot.
Business investment remains weak and is likely to impact on long-term growth in both profits and wages.
The decline is particularly steep in the Manufacturing sector and not just in Mining.
But government investment in infrastructure has cushioned the blow.
Profits in the non-financial sector remain low, apart from mining which has benefited from strong export demand.
Job vacancies are rising which should be good news for wage rates. But this also means higher inflation and, down the line, higher interest rates.
The housing and financial sector is our Achilles heel, with household debt climbing a wall of worry.
House prices are shrinking despite record low interest rates.
Broad money and credit growth are slowing, warning of a contraction.
Bank profits remain strong.
But capital ratios are low, with the bulk of profits distributed to shareholders as dividends. The ratios below are calculated on risk-weighted assets. Raw leverage ratios are a lot weaker.
One of the primary accelerants of the housing bubble and household debt has been $900 billion of offshore borrowings by domestic banks. The chickens are coming home to roost, with bank funding costs rising as the Fed hikes interest rates. In the last four months the 90-day bank bill swap rate (BBSW) jumped 34.5 basis points.
The banks face a tough choice: pass on higher interest rates to mortgage borrowers or accept narrower margins and a profit squeeze. With an estimated 30 percent of households already suffering from mortgage stress, any interest rate hikes will impact on both housing prices and delinquency rates.
I continue to avoid exposure to banks, particularly hybrids where many investors do not understand the risks.
I also remain cautious on mining because of a potential slow-down in China, with declining growth in investment and in retail sales.